The Implications of the VIX Swan Dive

by Tyler Craig | January 24, 2013 8:53 am

Alongside the S&P 500 Index’s march to new five-year highs, the CBOE Volatility Index (CBOE:VIX[1]) has plunged to new multiyear lows. Tuesday’s close of 12.43 in the so-called fear gauge was the lowest close since April 20, 2007.

Contrary to what some fearmongers would have you believe, however, the recent VIX dive is not an ominous development. Furthermore, the VIX isn’t all that low when you look at the totality of its history, or when compared to recent realized volatility. And finally, a low VIX can persist for years.

Let’s dig into each truth a little deeper.

A Low VIX Isn’t Bearish

Fellow Chartered Market Technician Ryan Detrick of Schaeffer’s Investment Research recently ran some numbers on how well the S&P 500 performed[2] when the VIX was above/below the 15 level. As shown in the accompanying table, the average one-month return of the S&P 500 was notably better with a sub-15 VIX.

At first blush, this might surprise some traders, but upon further reflection, it should make sense. After all, high VIX levels tend to be associated with corrections and bear markets, which aren’t exactly known for producing stellar returns. In contrast, low-volatility environments like the twin bull runs of the ’90s and 2003-07 have generated much better gains.

The VIX Isn’t THAT low

While a 12.43 print on the VIX might appear silly-low in a post-2008 world, it’s not all that uncommon when you survey the 20-year-plus history of the VIX index going all the way back to 1990. Also, bear in mind that the VIX Index is effectively the implied volatility for 30-day options on the S&P 500. As such, it rises and falls based on traders’ expectations of how volatile the market will be in the coming month.

With the 10-day historical volatility of the S&P 500 currently resting at a lowly 5%, the recent market volatility would have to double just to justify current VIX levels. In other words, the VIX isn’t all that low compared to how much the market is actually moving.

Low VIX Levels Can Linger

The final argument against becoming overly bearish in response to the recent VIX swoon is the fact that it can remain under the 20 level — or even 15 — for many moons. During the raging bull market of the ’90s and the more tempered housing-driven bull market of 2003-07, the VIX settled into a range in the low teens for a number of years.

Now, this isn’t to say that the VIX won’t experience the occasional surge this year. It might even venture north of 20 from time to time. Just remember it’s not a guarantee, and we could just as easily remain within a low VIX regime for an extended period of time.

But hey, if you think a storm is brewin’, I won’t argue with you for employing some stock replacement strategies or snatching up put options for insurance. They’re cheaper than they’ve been in a long, long time.

As of this writing, Tyler Craig owned bearish option positions on VIX-related ETNs.